Transcript Asset price bubbles and their implications for monetary policy

Asset Price Bubbles
and Monetary Policy
Pongsak Luangaram
Chulalongkorn University
December 2008
On the underlying causes
of the US financial crisis
Two schools of thoughts (White, 2008)
1. “What is different”
•
Focuses on new developments in financial markets,
e.g.
•
•
•
Massive expansion in sub-prime mortgage market
Development of new structured products
Reliance on ratings agencies in marketing them
2. “What is the same”
•
Interactions between asset markets and credit
market with the subsequent stress within the
financial system and the resulting damage on the
real economy
Fed and Bubbles
• How should central bank respond to asset price
bubbles?
• Recently, some news headlines:
– WSJ (17 Oct 08): ‘Fed rethinks stance on popping bubbles’
– Bloomberg (11 Dec 08): ‘Central banks can do better than just
mopping up’
• Fed Chairman Ben Bernanke (October 08):
– “[O]bviously, the last decade has shown that bursting bubbles
can be an extraordinarily dangerous and costly phenomenon for
the economy, and there is no doubt that as we emerge from the
financial crisis, we will all be looking at that issue and what can
be done about it.”
Received wisdom at the Fed
• Greenspan’s approach (mopping-up-after
strategy):
– Watchful waiting while prices rise and then
clearing up the mess after a bubble bursts.
• Bernanke’s approach:
– “[Monetary] policy should not respond to
changes in asset prices, except insofar as
they signal changes in expected inflation.”
(BG, 1999)
Received wisdom at the Fed
• In sum, “[A]s a general rule, the Fed will
do best by focusing its monetary policy
instruments on achieving its macro goal–
price stability and maximum sustainable
employment—while using its regulatory,
supervisory, and lender-of-last resort
powers to help ensure financial stability”.
(Bernanke, 2002).
Received wisdom at the Fed
• Frederic Mishkin (May, 2008):
– “[T]rying to prick asset price bubbles using monetary
policy is likely to do more harm than good.”
• Donald Kohn (November, 2008):
– “Despite our having learned that the aftermath of a
bubble can be far more painful than we imagined, I
am not convinced that the events of the past few
years and the current crisis demonstrate that central
banks should switching to trying to check speculative
activity through tighter monetary policy whenever they
perceived a bubble forming.”
Why?
• Identifying bubbles in a timely manner
• Ability of monetary policy to influence
bubbles
• Monetary policy is a blunt instrument
• It’s better to use financial regulation and
supervision
Identification problem
• Not all the fundamental factors driving asset
prices are directly observable
• Can the central bank know more than the
market?
• If mis-identified, slowdown in economic growth
• Even if bubble can be identified, there is
question of the timeliness
– What if the bubble is identified later than sooner?
Ability of monetary policy to
influence bubbles
• The influence of interest rates on the
speculative component of asset prices is
unclear
– Moderate policy actions might not be
adequate
– Too strong policy might cause a bubble to
burst more severely
Monetary policy is a blunt
instrument
• When there are many asset prices and a
bubble may be present in only a fraction of
assets. Monetary policy actions would be
likely to affect not just those in bubble but
asset prices in general
• So, risks associated with credit and asset
markets should be left to supervision and
regulation
Leaning against the wind
• The recognition that bubble can have potentially
destabilizing effects to the real economy when it
bursts
• All economic policy decisions are based on
some degree of uncertainty (such as estimations
of output gap and expected inflation)
– Uncertainty about bubbles is not reason to ignore
them and not to react to them. Monetary policy should
respond in a cautious and moderate manner.
• Asymmetric monetary policy responses can
create moral hazard problems (i.e. insurance
bubble; the Greenspan ‘put’)
Leaning against the wind
• In BG (1999), asset prices increase aggregate
demand (and hence price level). Hence a Taylor
rule that responds to inflation is also
automatically responding to asset prices
• In a world where asset prices affect real activity
directly because of collateral constraint (KM,
1997), there is a welfare-improving role for the
central bank to respond to asset price (Carlstrom
and Fuerst, 2001)
• Optimal policy requires leaning against bubble
(Filardo, 2004) (in contrast to BG)
Leaning against the wind
• Bubble may still emerge regardless of the quality of
financial market supervision and regulation
– Market can find ways to circumvent
• Policy instrument that relies exclusively on deviations
from inflation forecasts and the output gap—and then
injecting liquidity ex post in the event of a credit crunch,
may in certain circumstances be more costly in terms of
lost output than a proactive policy incorporating asset
prices directly into the central bank’s objective function.
(Bordo and Jeanne, 2002)
• Amplifying effect of monetary policy easing can lead to
housing boom (Shin, 2005; Taylor 2008)
Final remarks
• Open issue remains whether monetary
policy should react to asset prices or not.
But reassessment is seriously needed.
• It would be unwise to expect that low
inflation will, by itself, secure the
appropriate degree of financial stability
– Role of macro-prudential framework